Potential output

What's inflation telling us about the output gap?

MY COLLEAGUE makes many excellent points in this morning's post on potential output. We are, for the most part, singing from the same hymnal. For the most part, but not entirely. I must take issue with this:

My colleague [that is, me] says sluggish growth is no surprise, but the obvious result of too-tight monetary policy. But if monetary policy were systematically too tight, inflation should have fallen much further than it has; instead, both actual and (survey-based) expected inflation have been surprisingly stable, and higher than forecast by outfits like the IMF and the Fed who assign a relatively large weight to the output gap in the determination of inflation. The stability of inflation may be down to well-anchored inflation expectations, but this is ex-post reasoning; it's not an unambiguously superior explanation than reduced potential.

I disagree. First, the literature suggests that we should not expect accelerating disinflation in the presence of large output gaps. This is not based on an ex-post assessment that expectations are well anchored but on the ex-ante observation that wages and prices display substantial downward nominal rigidity. Inflation could also not have been much lower without becoming deflation, and the Fed has been aggressive in acting to prevent falling prices. That is not to say that monetary policy is appropriate; Fed policy has been easy enough to prevent deflation but not easy enough to allow for the faster-than-trend growth necessary to move the economy back to potential. It is also worth pointing out that most upward price pressure has been driven by resource costs; wage growth has been negligible through the recovery.

I would also disagree that expected inflation has been stable. The Cleveland Fed produces monthly analyses of inflation, inflation expectations, and the real interest rate. Here is a chart of 10-year inflation expectations since the beginning of the recession:

The steady downward trend is clear. On at least some measurements, both inflation and inflation expectations are behaving exactly as one would expect given a persistent, large output gap. Other measurements may not match up quite as well, but it seems clear to me that the large-output-gap story fits the data best.

We saw how accurately the market managed to predict the trajectory of home prices. The expected inflation rate cannot be possibly be wrong. There MUST be an output gap if the market believes there is an output gap.

RA--
With regards to the productivity matter, have you been to the Bureau of Labor Statistics charts on Multifactor Productivity growth? I'll quote their data directly (http://www.bls.gov/mfp/prodybar.htm):
"Multifactor productivity growth for the private nonfarm business sector
2007-2010 0.3"
"Multifactor productivity change in the manufacturing sector
2007-2009 -3.0"
This is sharply down (lowest in decades) from previous years which were mostly above 1.3 for priv. nonfarms and actually 2.0 between 00 and 07 for manufacturing.
I don't think I have seen anyone in the blogosphere plug this data yet. Curious to hear what you think.

"Fed policy has been easy enough to prevent deflation but not easy enough to allow for the faster-than-trend growth necessary to move the economy back to potential." (R.A.)

Am I the only person on the planet who is foolish enough to believe that there just may be forces other than monetary policy that are inhibiting growth - forces that monetary policy can't do a damn thing about? Perhaps the mistake is mine - monetary policy is omnipotent after all - but IDTS.

This Free Exchange blog is too U.S.-centric. It would be much better if this blog could be more balanced with contributions from places other than 'Washington'. The Economist can draw on plenty of editorial resources from across the globe.

Why would anyone think inflation should be dropping when it's already low? If that model makes sense at 8% inflation, why would it make sense at 1.5 or 2% inflation coupled with essentially 0 short term rates? The idea that one can mechanically apply a model is dumb: this is obviously not a normal economic time. Interest rates don't usually hover at 0 for over 3 years. They don't sometimes go negative when buyers literally pay to get a slightly negative yield.

Yes indeed, it's almost like a contemporary form of alchemy - just allow them push their fiscal levers and pull their monetary policy rabbits out of their hats and they will magically erase all the fallout from decades of financial irresponsibility (which they advocated as policy back then). Of course, in the process the national balance sheet is destroyed and the national currency is next in line.

We look down on Africans who are foolish enough to place faith in witchdoctors – yet, when it comes to economics, are we really any less foolish?